T he bear market in Treasuries continued last week as interest rates edged higher. Treasuries no longer benefited from a flight to quality because the Dow Jones Industrial Average gained 451 points last week, reversing some of the 630-point slide of the week before. Meanwhile, economic data continued to illustrate the economy's strength and give investors the jitters about inflation.

The 30-year Treasury yield rose to 6.34% by Friday from 6.26% the week before.

Last week investors learned that consumer prices jumped 0.4% in September and by 0.3% when energy and food prices are eliminated. The results were as expected. Investors also discovered that the August U.S. trade balance shrank, but remained huge. The deficit was $24.1 billion, slightly below July's level of $24.9 billion. Normally a smaller deficit would be viewed positively. However, this improvement occurred because U.S. exports rose 3.7% to $82.03 billion. The data only stoked fears that the U.S. economy was too strong and that global growth had picked up.

The trade numbers also confirmed that third-quarter gross domestic product will likely be strong. On average, analysts estimate that GDP grew 4% last quarter. They'll find out if they're right on Thursday.

True, the number may be abnormally high because of inventory building prior to the end of the year. And it may be boosted by revisions to GDP that are expected to make U.S. economic growth seem faster. Still, a 4% headline will be hard to ignore.

The market will also wait for the employment-cost index on Thursday. The measure of wages is expected to rise 0.9 percentage point. The fear, of course, is that either a strong GDP number or rising wages would give the Federal Reserve the ammunition it needs to raise interest rates at its November 14 meeting. Last week the Fed's European counterpart, the European Central Bank, left Euro-zone interest rates unchanged.

T he Federal Reserve once again showed that it's ready and willing to make sure the turn of the year goes smoothly. Last week it held its first auction of options on overnight repurchase agreements. The options give holders the right to conduct overnight repurchase agreements with the Fed on certain dates around yearend.

Then later in the week, the Fed announced that it would accept a wider variety of collateral if it makes loans to commercial banks at the discount windows of the regional Fed branches. Banks, which have been able to use Treasury and federal-agency securities as collateral, can now also use investment-grade certificates of deposit, commercial paper, collateralized bond and loan obligations and commercial mortgage-backed securities, according to the Dow Jones News Service.

The move was largely symbolic because banks turn to the discount window only as a last resort. However, it seemed to have an impact on swap spreads, which are considered a measure of risk in the financial system. The 10-year swap spread narrowed from the low-90s earlier in the week to about 86 by Friday's close.

"It's viewed as a measure to ease fears of a liquidity crunch at yearend," says James Glassman, senior U.S. economist at Chase Securities.

T obacco bonds got smoked last week after a Florida appeals-court decision clouded the future of these companies. The judges decided that a jury can award punitive damages in one "lump sum" to an entire group of individuals represented in a class action. Tobacco companies had hoped that the damages would be decided on an individual-by-individual basis, which would be much more time-consuming.

The ruling affects a class action in Florida, where the jury has already decided the tobacco companies are responsible for the deaths and illnesses of about 500,000 Florida smokers. In November, the same jury will sit down to award punitive damages. Investors fear the award, which could be handed down in two to three months, will be huge and the tobacco companies will have to post a bond while appealing the result.

There's also some concern that if the Florida smokers win, they'll encourage other individuals to bring lawsuits in other states. More court cases are not what tobacco companies need. The U.S. Department of Justice announced last month that it, too, would go after the tobacco companies. And they could be followed by insurance companies and a group of South American countries.

In the face of last week's decision, tobacco companies' stocks and bonds tanked. The yield on Philip Morris 7% bonds due in 2005 rose to about 7.88% from 7.57%, where they started the week. And the yield on RJ Reynolds Tobacco's 7 7/8 % bonds due 2009 rose to 9.58%.

So far, Moody's Investors Service and Standard & Poor's, have not changed their ratings. Philip Morris senior unsecured debt has a single-A rating from S&P and an A2-rating from Moody's. However, Egan-Jones Ratings, a smaller outfit based in Wynnewood, Pennsylvania, lowered its Philip Morris ratings for the second time since September to double-Bplus-one notch below investment grade. And within the next six months, it projects that the rating will again fall to double-B.

Similarly, RJ Reynolds Tobacco Holdings debt is rated triple-B-minus by S&P and Baa2 by Moody's. Neither rating changed last week. Meanwhile, EganJones dropped its RJR debt rating to single-B-plus and believes that within six months the ratings may drop to single-Bminus.

"Don't buy something that's cheap now but going to get cheaper," warns the firm's Sean Egan. He argues that the Florida smokers could get $500,000 each for a total award of $250 billion. "That's a lot of money and it's just Florida." The litigious fervor seems to be accelerating, he adds.

Egan-Jones bills itself as the agency that has no conflicts of interest because it doesn't ask issuers to pay it for ratings; investors pay the firm for its research. Last month, says Egan, Philip Morris tried to hire the agency to write a report that required a confidentiality agreement. Thanks, but no thanks was his reply. "If we were paid by them, it would be tough to be independent," said Egan. A Philip Morris spokesman wouldn't comment.

The Florida decision and the federal lawsuit have also cast a dark shadow over bonds that municipalities were planning to sell backed by revenues from a settlement they had struck with the tobacco companies. The tobacco companies agreed to pay states and municipalities a settlement over many years if the states and municipalities dropped all lawsuits. New York City and Nassau County, New York, are expected to be the first municipalities to try to sell such bonds in coming weeks. But it looks as though they could have a tough time trying with such cloudy issues making the bonds look much riskier.

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